Liquidity Risk Management

Liquidity Risk
Management
Managing Liquidity Risk in a New Funding
Environment
Peter Neu and Pascal Vogt
April 2012
Managing Liquidity Risk in a New Funding Environment
2
TABLE OF CONTENTS
Preface .................................................................................................................................................................... 2
The Elements and Shortcomings of Liquidity Risk Management ...................................................................... 3
View Liquidity Risk Management as an Enterprise-Wide Task ......................................................................... 4
Further Diversify Funding Sources ....................................................................................................................... 5
Pass on Funding Costs via Internal Transfer Pricing .......................................................................................... 7
References ............................................................................................................................................................ 10
Recent BCG Papers on Risk Management ......................................................................................................... 10
Authors .................................................................................................................................................................. 10
Preface
The recent financial crisis has revealed shortcomings in risk management that have imperiled not just
institutions but entire sectors of the financial-services industry. Banks and regulators have been quick to
address some of the most serious flaws and outlined significant changes under the so-called Basel III
framework. Capital and liquidity reserves are being increased, risk weights for market, securitization and
counterparty risk have been raised, a leverage ratio as a second line of defence has been proposed, and
stress tests and contingency plans are being reinforced. Liquidity risk is new on the regulatory agenda.
Basel III introduces two key liquidity requirements (see Box 1): the liquidity coverage ratio (LCR) and the
net stable funding ratio (NSFR). In a 2010 quantitative impact study (QIS), the Basel Committee and the
Committee of European Banking Supervisors (CEBS), estimated that the global banking industry would
need an additional €1.7 trillion in liquid assets to comply with LCR if banks were to make no changes in
the liquidity-risk profiles. Together, the new liquidity requirements will further complicate bank's
refinancing efforts. The ability of banks to manage the wall of refinancing in the coming years will hinge
on a number of factors, including the government efforts to resolve the sovereign-debt crisis. Banks can
ease their refinancing burdens by deleveraging and reducing their balance sheets and showcasing their
solvency – for example, by demonstrating strong wholesale-funding abilities.
But to prevent another crisis of this magnitude, banks must address the fundamental issues that
compromised their ability to manage risk. For example, risk management practices have been dulled by
an over-reliance on complex mathematical models, which have supplanted business judgment and have
allowed quantitative measures to trump qualitative insights. Banks should take actions to strengthen risk
management, in general, such as fostering a risk culture, redesigning incentive schemes, and reasserting
the role of business sense in risk management.
Prior to the crisis, liquidity risk did not receive as much attention—from regulators or banks—as other
threats, but it ended up magnifying and spreading the damage inflicted by credit and market risks. Few
banks now doubt the urgency to strengthen liquidity risk management. It is essential for restoring the
stability of banks and preventing another systemic financial crisis.
This chapter focuses on how banks should manage liquidity risk.
The Boston Consulting Group
April 2012
Managing Liquidity Risk in a New Funding Environment
The Elements and Shortcomings of
Liquidity Risk Management
In the broadest sense, liquidity is the capacity to
obtain cash when it is needed. While this
definition applies to all types of financial and nonfinancial enterprises, liquidity risk for a bank is
more specific. It is the risk that a financial
institution will be perceived as being unable to
meet present and anticipated cash-flow needs.
Liquidity risk can be segmented into three
categories: maturity mismatch risk, contingency
liquidity risk, and market liquidity risk.
Managing mismatches in cash flows is an integral
part of the business and a relatively
straightforward task. Maturity transformation is,
after all, one of the primary economic functions
that banks provide. Banks manage this risk by
holding a reserve of central-bank-eligible
securities.
Contingency and market liquidity risks are far
more difficult to manage. To understand these
risks, banks need to anticipate how markets and
customers will respond to extreme situations, and
how these responses, in turn, will affect the bank’s
funding ability and the saleability of its assets.
Contingency liquidity risk, for example, is the risk
of not having sufficient funds to meet sudden and
unexpected short-term obligations. By managing
this risk, a bank can safeguard its reputation to
meet its obligations, especially in times of crisis.
To do this, banks need to develop contingency
plans, keep a comfortable level of counterbalancing capacity and capital on hand, and
manage investors’ perceptions by disclosing the
bank’s liquidity profile and funding needs under
different scenarios.
The risk manager’s mission is the same across all
types of liquidity risk: to avoid a liquidity squeeze.
To this end, a risk manager needs to gather up-todate, transparent information about cash-flow
mismatches, contingency outflows, saleability of
assets, and counterbalancing capacity, and run
scenarios that test the bank’s capacity to handle
various threats. Risks are managed through
policies, limits, and contingency funding plans, as
well as through actions such as diversifying
funding sources. A good manager will also
demystify liquidity risk through clear reporting
and a comprehensive transfer-pricing system.
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Ultimately, however, liquidity risk managers can
only be effective if they are involved in an
enterprise-wide management and governance
process that links risk profiles to a bank’s strategy
and business model.
As critical as these practices are, many banks do
not have adequate capabilities for managing
liquidity risk. The crisis underscored the
widespread shortcomings of liquidity risk
management, which can be traced back to several
factors:

Banks took the pre-crisis condition –
ample market liquidity (in particular in
money markets), low volatility and low
interest rates – for granted and
underestimated the importance and
relevance of liquidity risk.

Contagion effects leading eventually to
excess liquidity needs (e.g., through
draw-downs on backstop facilities to
conduits, collateral needs in out-of-themoney derivative contracts) were illunderstood and not sufficiently
considered in stress scenarios. As a
consequence liquidity reserves where
too low and consisting of assets with
deteriorating market value; contingency
plans were inappropriate.

Pricing of liquidity risk was not
implemented rigorously. In particular
contingent liquidity risk in off-balance
sheet positions and refinancing risk in
structured tradable assets was priced
wrongly leading to an incentive for
traders to take excessive liquidity risk.
To a considerable part, the P&L of
structured desks resulted from a
liquidity arbitrage without having the
bank realizing and accounting for this.

Liquidity risk was not considered
sufficiently in banks’ strategic
discussion and planning processes.
Quite often treasurers became involved
very much at the end of the process
leading in some banks to excessive
cross-border and cross-currency funding
needs to match a strong asset growth.

Regulators did not thoroughly address
liquidity risk during the Basel II
consolidation process.
Regulators have recognized these shortcomings and have put strong emphasis on
liquidity risk in the newly issued Basel III
April 2012
Managing Liquidity Risk in a New Funding Environment
framework by introducing a quantitative
liquidity risk framework addressing both
short-term and structural liquidity risk (see
Box 1)


Many banks were not technically
capable of monitoring their gap profile
with the necessary detail and frequency.
Best-practice monitoring is a daily task.
It shows overall gaps as well as gaps by
region and currency, and under various
scenarios. Also, quantitative techniques
for forecasting cash outflows were not
always robust, and the counterbalancing capacity of many banks was
often insufficient under various stress
scenarios.
But technical faults were only part of
the reason why banks had difficulty
managing liquidity risk; resolving these
issues would not necessarily prevent
another financial meltdown. Deeper
problems stemmed from banks’ reliance
on purely quantitative approaches,
which suffer from a lack of business
judgment. In the case of liquidity risk,
qualitative judgment is particularly
critical—mathematical models will
cover only some of the elements that
contribute to a bank’s risk profile. As a
result, an emphasis on quantitative,
probabilistic methods severely
compromised the ability of risk
managers to understand implicit
liquidity risk in their banks’ business
models.
To begin addressing these flaws, banks need to
build a better information infrastructure—one
that is capable of tracking cash-flow mismatches
and contingency liquidity outflows. At a more
fundamental level, banks should use three levers
to transform their approach for managing
liquidity risk. These actions address the core
issues that have impeded efforts to control
liquidity risk:

View liquidity risk management as an
enterprise-wide task.

Further diversify funding sources.

Pass on funding costs via internal
transfer pricing.
View Liquidity Risk Management as
an Enterprise-Wide Task
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In many banks, liquidity risk has been treated as
just another risk category. Banks built discrete
silos and ran isolated stress scenarios to manage
liquidity risk. As a result, there has been little
meaningful collaboration or communication
between this functions and the “business” side of
the bank, which determines the bank’s business
model and strategy.
The financial crisis has shown that liquidity risk
management must be treated as an enterprisewide task, for two reasons. First, liquidity risk can
both stem from and contribute to other kinds of
risk, namely credit and market risk, thereby
creating a vicious cycle. Liquidity risk might
emerge from problems in the bank’s loan book,
large trading or operational losses, or doubts
among investors or rating agencies about the
bank’s business model. Markets will penalize a
bank that has excessive credit risk by restricting its
access to stable funding. Dependence on shortterm funding will, in turn, increase liquidity risk
and amplify the effects of credit and market risk.
As such liquidity risk is closely connected to
capital and losses in P&L.
Second, liquidity risk poses an extreme and often
hidden threat. In contrast to market, operational,
and credit risks—which result in realized losses
nearly every day—liquidity risk is inconspicuous
during normal times. Even when a bank’s level of
underlying liquidity risk is extraordinary, it can
stay dormant until a crisis emerges. Once
triggered, however, liquidity risk can quickly
threaten a bank’s existence.
Banks can take several steps to ensure that
liquidity risk management becomes an enterprisewide issue.
Set up an Extreme Risk Team. Liquidity risk
managers cover a lot of ground. They must pay
attention to anything in a bank’s operating or
business model that might disturb the cash-flow
balance or lead to concerns about the bank’s
stability. To help them think and act
strategically—with an enterprise-wide
perspective—liquidity risk managers should
participate in an Extreme Risk Team that:

Analyzes vulnerabilities in the bank’s
business model, mainly by simulating
extreme events. The team should also
look for weak signals of increased
liquidity risk, which are not always
negative or necessarily alarming—a
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Managing Liquidity Risk in a New Funding Environment


warning sign might be a line of business
that is growing too fast or is too
profitable. In addition, the team should
be responsible for turning weak signals
into strong ones, mainly by detecting
patterns.
Assesses how competitors, investors, or
rating agencies regard the bank.
Liquidity risk can pose a serious threat
to a bank’s reputation.
Gauges the bank’s exposure to
deteriorating markets. How quickly
could the bank unwind assets, and at
what cost against the bank’s capital?
How diversified is the bank’s funding
and how much depends on short-term
wholesale funding? How quickly could
the bank deleverage the balance sheet
and at what cost against the bank’s
capital?
Define suitable stress scenarios. To be relevant,
stress tests cannot focus exclusively on
improbable events. They must also cover some
fairly plausible, even likely, scenarios. In addition,
they should account for a contagion effect among
markets, risk categories, and business lines. For
instance, falling market values in counterbalancing capacity and increased haircuts will
heighten the bank’s dependence on unsecured
funding. A decrease in interest rates will drive
hedges of fixed-rate loan books out of the money
and trigger cash collateral calls even though there
is no net P&L impact for the bank due to fairvalue hedge accounting. Downgrades will lead to
cuts in inter-bank credit lines and trigger collateral
calls in derivative contracts and backstop lines.
Treasury might even be forced to serve
uncommitted lines for reputation reasons.
Recognize the link between liquidity risk and
capital. As laid out before, liquidity risk is often
recognized as a consecutive risk, frequently
emerging from P&L-problems in banks’ loan or
trading books. Albeit this is true, this can only
happen if the bank has a weak balance sheet
structure, e.g., strong dependence on unsecured
short-term funding (often in foreign currencies),
insufficient fungible assets and low term-funding
ratios. Nonetheless, there is a clear link between
capital- or P&L-at-risk and liquidity which is
demand for collateral. Examples are CSA
agreements in derivative contracts, margin calls in
futures, haircuts in repo funding or
overcollateralization in covered bonds. In any
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case deteriorating markets and asset values lead
to increased collateral demand and pose a
significant liquidity risk to banks. To manage this
risk banks must consider correlations between
different risk factors which can enhance the
problem. An example of the last crisis was the link
between decreasing long-term interest rates and
increasing credit spreads: Banks hedging their fix
rate commercial loan book with payer swaps were
faced with increasing collateral calls when term
rates decreased. Simultaneously, the cash value of
some of their liquidity reserve held in sovereign
securities deteriorated due to increasing credit
spreads. Hence prudent collateral management
including appropriate haircuts on securities’
market value, bilateral collateral agreements in
derivative contracts, sufficient cash reserves in all
relevant currencies and foreword looking stress
tests are key.
Develop an integrated view of risk. As a result
of such interdependencies, banks must bring
together managers from all risk categories and
business lines in order to understand the
complicated links among scenario outcomes, the
bank’s business model, market trends, and
behavioral issues. Moreover, liquidity managers—
either via a committee or an independent CRO
function—must be allowed to mitigate excessive
liquidity risk by setting limits such as maximum
cash outflow, minimum reserve on
counterbalancing capacity, maximum unsecured
funding, minimum funding ratio, and maximum
loan-to-deposit ratio.
Liquidity managers should be able to do this for
the bank as a whole, as well as for individual
business lines. The liquidity risk function should
also have veto power over decisions involving the
bank’s business model.
Further Diversify Funding Sources
The difference between non-bank loans and nonbank deposits is a good indicator of a bank’s
funding need. The loan-to-deposit gap in the Euro
area widened to €1.5 trillion in November 2007,
resulting in a loan-to-deposit ratio of 114 percent
(See Exhibit 1) Banks had to close the funding gap
using inter-bank, money, and capital market
instruments, but the crisis has caused these
markets to dry up, leading to a dramatic liquidity
squeeze for many banks. Bank's reacted by
deleveraging their balance sheets and by raising
stable deposits leading to a reduced funding gap
April 2012
Managing Liquidity Risk in a New Funding Environment
of €0.9 trillion and 108 percent loan-to-deposit
ratio by the end of 2011.
Banks that are less dependent on wholesale
funding have had fewer difficulties in this crisis.
The retail-banking business model, for example,
has proven to be much more insulated from
illiquidity. However, in many countries extended
government protection of retail deposits helped
significantly to stabilize the system and to avoid
bank-runs (e.g. in Germany). In order to avoid
excessive dependence on wholesale funding,
banks are trying to tap funding from retail and
SME depositors. Not surprisingly, many wholesale
banks have, in the wake of the crisis, reacquired
or reawakened their retail branch networks, and
some former investment banks are looking to
build or acquire a retail portfolio.
The prominence of short-term funding strains the
liquidity profile of banks. (See Box 2 “Evolution of
Euro-area aggregated liability structure since
1997”) Higher dependence on volatile funding
increases structural liquidity risk, while extensive
off-balance-sheet commitments—including
covenants, downgrade trigger, and ABCP
backstop lines—increase contingency liquidity risk.
The differences between the pre- and postcrisis
funding mixes are clear, and have led to a number
of trends (see Box 2):

Unsecured and even secured inter-bank
markets have been severely affected by
concerns about banks’ stability.

Short-term unsecured money-market
funding, bank bond, and securitization
markets are almost completely dried up.

Central banks are trying to fill the void
by boosting their open-market
operations.

Funding spreads are increasing
dramatically.

Banks are trying to improve their
funding ratios and are concentrating on
raising stable non-bank deposits.

Banks are also trying to deleverage their
balance sheets and reduce their offbalance-sheet liquidity contingencies.
Understand the crisis-induced changes to
funding sources. As outlined above, the crisis
showed clear differences between funding needs
in normal and stressed markets. We believe that
the funding mix and balance-sheet structure will
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continue to change dramatically. The unsecured
inter-bank funding market will lose the
importance it had before the crisis deepened—it
will stay dry and will be more regulated. It will be
replaced by secured ECB or inter-bank funding,
along with a slight increase in non-bank deposits.
Banks will reduce maturity transformations and
contingency liquidity risk. Additionally, continued
deleveraging—spurred by regulators and
investors—will lead to smaller balance sheets and
higher capital ratios.
As they aim to diversify their sources of funding,
banks must look more closely at the changes that
are affecting different markets:

Inter-bank funding suffers from a lack of
trust and liquidity, brought about by
uncertainty over the liquidity situation
in banks and by more sensitive credit
assessments. Even the inter-bank repo
market has been affected.

Money and capital markets have been
severely hit by the crisis. Short-term
commercial paper, banking bonds, and
securitization markets have gone cold.
(See the sidebar “Money and capital
markets have dried up.”). Recent
government guarantees for bond issues
in France, Germany, the United
Kingdom, and the United States provide
some reassurance, but these are only
short- or medium-term interventions.
They will not solve any underlying
problems.
In addition, the downturn of
securitization markets has eliminated
investment-banking products that were
widely used before the crisis. It has also
led to the downfall of profitable
business models and institutions.
Strategic changes have to be made in
many business models.

Central banks reacted to dried-up
funding by boosting their open-market
operations. After the collapse of
Lehman Brothers, central banks
stretched their activities to calm
markets and prevent knock-on effects.
ECB extended its open-market
transactions by 264 percent from Q1
2008 to Q4 2011. These transactions
surged in September 2008, after
Lehman Brothers fell. During 2009, the
ECB was able to reduce its exposure
slightly, but it is still at double levels
April 2012
Managing Liquidity Risk in a New Funding Environment



compared to its pre-crisis engagement
(see Exhibit 4.). Additionally, central
banks focused to extend the catalogue
for central bank eligible assets and to
establish programs to directly purchase
assets from the market. Moreover,
additional banks were enabled to
benefit from central bank funding (e.g.
by the transformation of the US
Investment Banks into Commercial
Banks). As term funding markets were
again heavily affected by the sovereign
crisis, the ECB reacted in December
2011 and February 2012 with two 3Y
tender operations floating the market
with €500bn term funding to prevent
another systemic crisis.
Non-bank deposits have increased. When
liquidity became expensive and scarce,
many banks focused their attention on
retail money. At the same time,
investors were looking for a safe haven
for their savings. As a consequence,
Euro-area term deposits grew by more
than 16 percent from 2007 to 2011,
from €10.3 trillion to €12.1 trillion,
driven largely by households and
insurance companies.
Funding spreads are rising. Already
hobbled by massive write-downs, banks
will need to cope with soaring funding
costs. Bank bond spreads fell by 45
percent from 2001 to 2007 but have
increased by roughly 230 percent
between July 2007 and January 2009.
(see Exhibit 5). Despite the recovery of
spread levels during 2009/10, the
sovereign –crisis boosted spreads back
to their peak-levels by the end of 2011.
ABS and ABCP spreads were
significantly underestimated by the
market when it was full of liquidity, and
the adjustment to a postcrisis level is
not over.
Off-balance-sheet liquidity contingencies
will continue to fall. Liquidity risk from
off-balance-sheet commitments such as
backstop lines, downgrade triggers, and
other covenants will be reduced and
will be much more closely managed (via
limits and liquidity costs). European
ABCP issuance dropped by 70 percent
from 2007 to 2011 (see Exhibit 4).
7
Improve the funding mix. The shifts occurring
among various sources of funding should compel
banks to make five significant changes to the
funding mix:

Reduce maturity transformation and
dependence on wholesale funding that
can disappear at any time, such as
unsecured and secured money markets
funding.

Reduce contingency liquidity risk by
cutting (or at least monitoring more
closely) committed and uncommitted
credit lines; enforcing bilateral
collateral agreements in derivative
contracts; and scrutinizing covenants in
loan contracts that relate to liquidity
outflows (for example, downgrade
trigger).

Build a stable base of retail deposits by
crediting funding costs to originating
units, defining target loan-to-deposit
ratios in the planning process, and
redefining business models (for
example, allowing origination units to
offer attractive client rates in order to
boost deposits.)

Reduce cross-border/cross-currency
funding and incentivize funding in local
currencies, ideally from non-banks.

Focus on central-bank-eligible collateral
as a liquidity reserve and implement a
central collateral-management process
that rewards liquefiable collateral.
In addition to these long-term measures, many
banks already benefit in the short-term from the
singular opportunity of government capital
injections to overcome the current situation.
Pass on Funding Costs via Internal
Transfer Pricing
The financial crisis has shown that banks
overestimated the liquidity of certain asset classes
such as ABS and tranches of CDOs, and
underestimated potential drawdowns in some
backstop credit lines to SPVs. As a consequence,
credit lines were mispriced, structured credit
assets came to rely on short-term funding from
money markets, the cost-of-carry was
underestimated, and traders increased their
profits linearly with the size of their carry-trade
book.
Before the crisis, many banks generated
substantial liquidity risk, even if they did not fully
The Boston Consulting Group
April 2012
Managing Liquidity Risk in a New Funding Environment
understand its origins and consequences.
Moreover, few banks had incentives to manage or
control liquidity risk. In fact, some had explicit
strategies for boosting short-term profits by
assuming more liquidity risk. Most banks followed
this strategy without understanding the economic
reason behind excess profits in structured credit
products shown in traders’ P&L and paid-out
bonuses.
Leading banks have since expanded their liquidity
transfer-price system to include all on- and offbalance-sheet assets and liabilities. As a result,
banks have reduced the incentives for their
originating and trading units to generate (risk-free)
profits by taking advantage of mispriced funding.
They have also identified the inherent liquidity
risk in products and business models and have
transferred the management of this risk to a
central unit in Treasury.
A prudent liquidity transfer-price system consists
of three components: pricing structural liquidity
risk, pricing contingency liquidity risk, and pricing
market liquidity risk.
Price structural liquidity risk. Most banks
already transfer the cost of issuing long-term debt
from Treasury to the units that originate longterm sticky assets, such as term loans. With the
same logic, units that originate stable deposits
from retail or corporate clients should be credited
opportunity funding costs.
Price contingency liquidity risk. Fewer banks
have allocated contingency and market liquidity
costs. Treasurers tend to retain unencumbered
liquid assets, which are usually central-bankeligible, as collateral for contingency liquidity risk
arising from, say, unexpected draws on credit
lines, excess collateral for out-of-the-money
derivative contracts, or minimum reserves for
settlement transactions. Treasurers earmark these
securities either by internal lending or by a true
asset transfer to their own portfolio. Depending
on the bank’s liquidity risk appetite, these
securities are then funded unsecured at term
(from one week to up to 6 to 12 months). In a
crisis, these assets are used as collateral for
central bank or inter-bank repos and thereby
generate excess liquidity.
The size and funding horizon of such a liquidity
buffer do not depend on stringent arithmetic or
statistical calculations but rather are derived from
scenario analysis of the liquidity exposure under
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the bank’s business model and risk appetite. A
liquidity risk manager might, for example, analyze
the size of credit lines, their potential drawdowns,
and the potential collateral demand from the
bank’s derivative portfolio.
Price market liquidity risk. Finally, market
liquidity costs need to be allocated to tradable
assets—a concept that recently received
acceptance on trading floors due to the crisis.
Before the crisis, most investment-grade assets
could be sold on short notice in the market at fair
value. As a result, even highly structured, opaque
assets were funded short-term in the money
markets. In fact, the funding at Euribor, together
with a low regulatory capital charge, were the
core of the business model for many banks in the
end most damaging carry trade book in structured
credits. During the crisis, when these assets
deteriorated in price and strained banks’ capital,
the secondary markets dried out and banks found
themselves facing a liquidity squeeze because of
their reliance on short-term funding.
As a consequence, leading banks have changed
the funding strategy for running their investment
and structured credits book. Instead of using the
usual overnight rate, banks use the calculated
cost-of-carry with respect to the unwinding
horizon of positions. To implement this concept,
banks must consider several details that
determine the unwinding horizon and the
required unsecured funding (for example, the
typical daily turnover of the security relative to
the bank’s position, repo eligibility, central bank
eligibility, and embedding in hedge group with a
derivative contract on the client side such as
securities held as hedge in a total return swap).
Put liquidity pricing into practice.
Implementing a liquidity transfer-pricing system is
a delicate task, given that banks’ funding costs
have soared. To be successful, a transfer-pricing
system should strike a balance between the needs
of liquidity risk managers and the sales units.
Quite often, liquidity transfer-pricing is criticized
by originating units for interfering with their
targets for growing market share or revenue. But
a bank’s funding costs are real, and they reflect
the bank’s competitive position in the market. If
these costs are not passed on to the customer, the
bank will not be profitable in the long run.
To ensure that a liquidity transfer-pricing system
is efficient and fair, Treasury must generate
April 2012
Managing Liquidity Risk in a New Funding Environment
neither a profit nor a loss from the bank’s funding
position. It can do this by following five principles:

Liquidity costs are calculated on the
basis of the bank’s marginal funding
costs. Treasury must use a blended rate
for term-issues in the institution’s own
funding instruments such as listed debt,
private placements, and covered bonds.

Liquidity costs for business lines are
debited and credited. This gives
incentives to originating units to
underwrite loans and raise deposits and
collateral. Originating units may net
these costs on a portfolio basis, thereby
achieving a more competitive customer
rate for key clients.

Liquidity costs are calculated assuming
matched funding with respect to the
liquidation horizon (See the sidebar
“Transfer-pricing methodology and
evolution of liquidity cost.”). Benefits
from a maturity transformation are
shown in the Treasury P&L. However,
Treasury may lower the term funding
curve according to expected profits
from a target maturity transformation
corresponding to a funding ratio limit
below 100 percent.

Liquidity costs are calculated with
respect to the liquidation horizon.
Treasury must use behavioral and not
contractual cash flows. Behavioral
adjustments refer to product-types
(such as project finance, sight deposits,
current accounts), clients (retail, SME,
wholesale), or markets (sale of
securities). The aim is to use products,
clients, or market specifications to
lower transfer rates. For this to work,
banks must introduce a mechanism that
penalizes significant deviations from
expected behavior.

Cost-of-carry for tradable assets must be
calculated with respect to the
unwinding horizon of the entire
portfolio. Treasury must reduce funding
costs when assets are self-funding in the
repo market (inter-bank or with central
banks). Some attractive products may
become unprofitable when liquidity
costs are correctly allocated.
*
*
The Boston Consulting Group
9
The financial crisis has demonstrated, with
alarming clarity, the consequences of
underestimating liquidity risk. For many banks,
improving liquidity risk management will require
fundamental change.
Banks must elevate liquidity risk management to
an enterprise-wide discipline that contributes to,
and is informed by, a bank’s business model and
strategy. And given the extreme (and often
hidden) nature of liquidity risk, banks should
develop a deep understanding of their balancesheet dynamics—one that encompasses all risk
categories and synthesizes their implications for
liquidity and capital. At the same time, an
empowered risk function, backed by an Extreme
Risk Team, will need to be at the heart of a bank’s
decision-making processes.
In addition, liquidity risk managers will need to
focus squarely on the funding challenge. Funding
has become much more difficult and expensive to
acquire. Spreads have widened across the board,
and many funding markets have dried up
completely. In the short-term, banks will have to
rely on money from central banks and funding
from deposits, which are experiencing a
renaissance. In the long term, banks will need to
concentrate on diversifying their sources of
funding.
A more prudent approach to liquidity
management—with a strong focus on cross-border
and cross-currency funding exposure, collateral
management, and liquidity transfer-pricing—will
be critical to success, particularly as banks’
funding mix and balance-sheet structures
continue to change. The unsecured inter-bank
funding market will lose its importance as a
funding source, for example, and will be replaced
by secured ECB or inter-bank funding and nonbank deposits. Banks will also deleverage their
balance sheets, reduce maturity transformation
and contingency liquidity risk, and increase
capital ratios.
Banks that establish empowered, capable
functions for managing liquidity risk will not only
accelerate their recovery from this crisis, but will
also find themselves in a much stronger strategic
position.
*
April 2012
Managing Liquidity Risk in a New Funding Environment
Acknowledgments. The authors would like to
thank Carsten Heinen and Kyrill Radev who
supported the preparation of this article as well as
Robert Fiedler and Leonard Matz for their
valuable input.
References
Principles for Sound Liquidity Risk Management
and Supervision, BCBS, June 2008
Second Part of CEBC’s technical advice to the
European Commission on liquidity risk
management, September 2008
Strengthening liquidity standards, FSA
Consultation Paper, December 2008
Enterprise-wide Liquidity Risk Management—Still
slipping through our fingers? Jonathan York, The
RMA Journal, September 2008
The Turner Review: A regulatory response to the
global banking crisis, FSA, March 2009
10
Facing new Realities in Global Banking – BCG Risk
Report 2011, by Ranu Dayal, Gerold Grassoff,
Douglas Jackson, Philippe Morel and Peter Neu,
December 2011
Authors
Peter Neu
Partner and Managing Director, Risk Expert Team
BCG Frankfurt
+49 69 9150 2160
[email protected]
Pascal Vogt
Project Leader, Risk Expert Team
BCG Cologne
+49 221 5500 5213
[email protected]
FSA discussion paper: A regulatory response to
the global banking crisis, FSA 2009
International framework for liquidity risk
measurement, standards and monitoring, BIS
Consultative Document, BCBS December 2009
International framework for liquidity risk
measurement, standards and monitoring –
Update of Annex, BCBS, July 2010
The Basel Committee’s response to the financial
crisis: report to the G20, BCBS October 2010
Recent BCG Papers on Risk
Management
Operational Risk Management: Too Important to Fail,
by Pierre Pourquery and Johan de Mulder,
February 2009
New Risk Regime, by Philippe Morel, Peter Neu,
Pierre Pourquery and Duncan Martin, December
2008
All Dried Up: The Impact of the Subprime Crisis on
Liquidity Risk Management, by Peter Neu and
Philippe Morel, May 2008
The Current Crisis: Is the Worst Behind Us? by
Philippe Morel and Pierre Pourquery, March 2008
The Subprime Crisis: Do Not Ignore the Risks, by
Philippe Morel, Pierre Pourquery and Peter Neu,
September 2007
The Boston Consulting Group
April 2012
Managing Liquidity Risk in a New Funding Environment
11
Box 1: Basel III introduces key ratios for Liquidity Management
Basel II covered liquidity risk originally under Pillar 2 referring to the Sound practices paper from the BCBS from 2000. In
this document all relevant topics were addressed. However, implementation of these standards lagged with banks being
more than busy and budgets being more than tight with Pillar 1 topics. In addition there was ample liquidity in the market
leading to different priorities at both the regulatory and the banking side. The crisis has shown however that liquidity risk
is real and its proper management is crucial.
In December 2009 the BCBS has proposed two new global measures for managing liquidity risk – going for the first time
from the previous qualitative to a quantitative approach: a (stressed) 1-month liquidity coverage ratio (LCR) and a
structural (> 1 year) net stable funding ratio. The former ratio is to immunise banks for short-term liquidity shocks
(liquidity reserve). The latter limits the refinancing risk and the maturity transformation in funding. See the BIS document
International framework for liquidity risk measurement, standards and monitoring from December 2009 and the update from
July 2010 for the definition of qualifying liquid assets and the product specific weighting factors to determine the net cash
outflows.
Source: International framework for liquidity risk measurement, standards and monitoring, BIS-consultation document,
Dec 2009, update of Annex in July 2010
The Boston Consulting Group
April 2012
Managing Liquidity Risk in a New Funding Environment
12
Exhibit 1: Aggregated funding gap of Euro-area credit
institutions
1. Loans to non-banks 2. Deposits of non-banks
3. Certified liabilities issued by banks and building associations
4. Dezember 2011
Source: ECB; Bloomberg
Exhibit 2: Euro-area1 aggregated balance sheet in
December 2011
1. MFI (exkl. Eurosystem), ex Euro zone positions allocated
2. Incl. reverse repos
Securities and loans to banks vs. short term liabilities (<1Y)
4. Loans to non-banks and other assets vs. >1Y liabilities
3.
Source: ECB, Bloomberg, BCG analysis
Exhibit 3: Evolution of European1 ABCP issuances
1. Incl. UK
Source: 2006-Q3 2011 AFME Securitisation Data Report
The Boston Consulting Group
April 2012
Managing Liquidity Risk in a New Funding Environment
13
Box 2: Evolution of Euro-area aggregated liability structure since 1997
Share of total liabilities
Delta 2008 vs. 2000 in PP1
Share of total liabilities
Delta 2011 vs. 2008 in PP
€ Trillion
Money market
f unds
40
CAGR 2000-2008 and 2008-2011
1.8 %
31.8
30
29.5
8.4 %
31.1
32.2
26.0
23.6
20
16.7
18.2
18.8
19.8
0.7
-0.9
33.6
21.4
10
ECB f unding
Deposits
of banks
3.1
-3.6
-6.6
Deposits
of non-banks
-1.2
Issued
bonds
-1.1
Equity &
other liabilities
2.4
0.9
-0.4
2.2
4.8
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
1. Percentage points; Source: ECB, Bloomberg
Box 3: Money and capital markets have dried up in 2009
1. ECB statistic 2. UK resident MFI 3. Year-end levels financials 4. Non-convertible bonds; incl. non-Euro area countries
(Thomson Financial category); Source: Bank of England; ECB; Federal Reserve volume statistics; Thompson Financial;
Bloomberg
The Boston Consulting Group
April 2012
Managing Liquidity Risk in a New Funding Environment
14
Exhibit 4: ECB open market transactions and lending1
1. Marginal lending and other claims on Euro area credit institutions, main refinancing, long-term
refinancing and fine-tuning operations
Source: ECB
Exhibit 5: Evolution of bank-financing1
1. Spread over government securities of comparable maturity
Source: Bloomberg; ECB
The Boston Consulting Group
April 2012
Managing Liquidity Risk in a New Funding Environment
15
Box 4: Transfer-pricing methodology and evolution of liquidity cost
1. Exemplary European Bank funding curve 2. Euro Swap curve 3. European Sovereign Benchmark curve 4. Euribor 5.
Eurepo
Note: Curves as of 31 Dec 2010, 31 Dec 2011 and 29 Feb 2012 respectively.
Source: Bloomberg; BCG analysis
The Boston Consulting Group
April 2012